I think the main thing (other than doing a lot of research) is to not connect the xbox to live without the hdd or the disc drive installed - that can get your account banned as they think you're trying to use a hacked console...

Options to "replace" (upgrade) your 360's capacity that I know of are:
-Remove the old hard drive (simply unplug it from the top) and stick a new one in.
-Plug an external drive (HDD or Flash Drive) into it via USB.

I am really not sure what you are trying to do that would be against the T&Cs.

Then you can:
-Transport the data easier
-Transfer the data easier
-Use the drive for other stuff

Actually swapping the drive and installing firmware was only necessary when 360s didn't support other drives. You can use any HDD / memory device now as far as I am aware.

I use my flash drive for a few things, and I know people that use large 3.5" drives.

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To answer your questions about the method you want to use in the OP:
-I haven't done it before, but I've taking apart my 360 enough times and I don't think you will break anything.
-Yes, it will be against the T&Cs and will void the hard drives warranty (but this will have expired so it doesn't matter)
-No, you won't get banned (I don't think)
-I don't think it matters which HDD you use.
-I don't know if you will need to install the firmware on it. You definitely don't have to if you plug it in via USB, but I'm not sure if connecting in that way will mean otherwise.

So in conclusion, I would recommend just using an external drive plugged in via USB:
-It takes less effort
-It provides more flexibility
-It will definitely work
-It won't break any of the T&Cs

This is the older style xbox, I was always under the impression that external drives wouldn't work, I also want him to be able to install his games to the drive so that the dvd drives isn't constantly spinning and making a hell of a din.

This is the older style xbox, I was always under the impression that external drives wouldn't work, I also want him to be able to install his games to the drive so that the dvd drives isn't constantly spinning and making a hell of a din.

I don't think it matters which xbox it is (assuming by older style you mean the original 360 and not original xbox). There was a firmware update which allows any storage device to be used.

Asked someone I know, they said:
-Connecting by USB will only work for memory sticks
-If you want to use a HDD, then you were right, you have to dismantle the 360 cage and replace it.
-The HDD should be a 2.5" Western Digital drive. Apparently the Scorpio Blue is good. Might wanna do some more research.